YOUR TAXES:M&A: If you want IP don’t buy shares

Matters came to a head in 2018 when the Israeli Tax Authority (ITA) won a victory against the mighty Microsoft – in the GTEKO case.

money (photo credit: REUTERS)
(photo credit: REUTERS)
When US multinationals buy out the shareholders of an Israeli tech company, they often don’t realize that moving the technology out of the company – subsequently to a group IP affiliate – will trigger an Israeli tax. This is in addition to any Israeli tax that is already paid by the selling shareholders, i.e. double taxation.
In the US, Section 338 of the Internal Revenue Code may allow an acquirer to step up the value of a corporation’s assets to the value of its stock (shares) for US tax purposes to avoid double taxation. Israel does not have a Section 338.
Matters came to a head in 2018 when the Israeli Tax Authority (ITA) won a victory against the mighty Microsoft – in the GTEKO case. Now the ITA has issued a Circular (15/2018 of December 1, 2018) explaining when it will tax corporate reorganizations, especially those that shuffle intellectual property (IP) around.
The GTEKO Case:
In November 2006, Microsoft Corporation of the US bought all the shares of GTEKO, an Israeli tech company, for $90 million. A month later, the GTEKO work force was moved over to Microsoft Israel. Their services were then billed out on a cost plus basis.
Six months later, GTEKO entered into an agreement with Microsoft to “sell and transfer… all of GTEKO’s rights, title and interest in and to any and all intellectual property that GTEKO currently owns…” at a valuation of only $27 million. The taxpayer argued that marketing tangibles were left in GTEKO and Microsoft already owned synergy.
The court attributed value to the assembled work force and ruled that IP could not simply “evaporate.” Therefore, the fair market value of the IP transferred remained $90 million.
The judge added a significant side comment (obiter dicta) – the ITA could have claimed the IP transfer was done in an artificial or fictitious manner. The USA has a similar sham doctrine. (GTEKO Ltd v. Kfar Saba Tax Office, Ramle District Court, June 6, 2017 Civil Appeal 49444-01-13).
The Circular:
The Circular cites the GTEKO judgment and even claims it is applying OECD transfer pricing guidelines. The ITA says that if a corporate reorganization results in a sale of IP, Israeli capital gains tax is due. If the IP is merely licensed, royalties should be taxed.
The way to assess what happened is to review not only agreements and purchase price allocations (PPAs), but also functions assets and risks (FAR) before and after the reorganization. And to value the gain arising, there may be a comparable uncontrolled price (CUP) such as a share purchase price, going concern price, enterprise value before deducting debt, fund-raising round valuation or stock exchange price.
Otherwise, discounted cash flow principles may be applied. The discount factor may be the internal rate of return or the weighted average cost of capital. Integration bonuses may be added unless they are separately taxed.
The ITA also points out that if functions, assets and risks are scaled back, the company may no longer qualify for preferred enterprise and technological enterprise tax breaks. The Circular includes a detailed questionnaire for taxpayers to fill in to make it easier for the ITA to then tax them.
We doubt whether the OECD transfer pricing guidelines really support the ITA in its quest for double taxation. The ITA needs to adjust its optics.
Any multinational planning to acquire an Israeli company for its IP had better get it right, otherwise there will be double taxation – on the share acquisition and on a subsequent transfer of IP out of Israel.
Possibilities to consider may include buying the IP itself, and not the shares of the Israeli tech company. If you must acquire the shares (because it reduces the sellers’ tax bill), consider leaving the IP in the Israeli company and licensing out the use of the IP.
Alternatively, consider carefully a joint venture that will develop the next generation of IP – but leave the current generation in Israel. If all of this seems too complicated, seek local Israeli professional advice.
And if you are on the exit side, it just got harder to sell shares and save tax. It may be better to ask for a higher price.
Furthermore, every deal has other important facets to consider from structuring the business to integrating the two sides efficiently.
Doing your homework is necessary.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd